Why the Fundamental Case for Stocks Is Positive

Here, a look at some of the key drivers of stock prices.

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Nothing it seems, not even a Congress bent on self-destruction, can stand in the market's way. With each new high, more pundits come out of the woodwork to warn of imminent doom. The market is just another Fed-induced bubble ready to burst, they say. The fundamentals just don't support the level of stock prices. After all, if the economy is only growing at a snail's pace, why should the market be up over 25% so far this year?

While I do have some concerns here, particularly around investor sentiment, I think the fundamental case for stocks actually remains quite positive. Let's take a look at some of the key drivers of stock prices.

Economic Growth

The economy is far from robust, but the recession many called for has not materialized and the economy continues to grind slowly higher. The government shutdown will likely reduce growth in the fourth quarter, but that effect should be temporary (assuming we don't have another shutdown in early 2014!).

While the long-awaited acceleration in the economy has not materialized either, the current modest growth is still positive for stocks.

In fact, one could argue that such modest growth is actually a "Goldilocks" scenario-strong enough to help corporate earnings, but weak enough to keep interest rates and inflation in check and the Fed in full support mode.

Interest Rates

Interest rates have been rising this year and the trend is higher-although rates on the 10-year Treasury are now down about 50 basis points from their high of almost 3%, reached in September. Nevertheless, rates remain extremely low by historical standards and we expect the rate of increase to be modest-in line with the economy.

This is especially true with the Fed continuing to keep short rates near zero and with tapering seemingly now off the table for some time. At these low rates, bonds offer less competition for stocks, and corporations benefit from low borrowing costs.

Corporate Earnings

Earnings growth for the S&P 500 (INDEXSP:.INX) in the first half of this year was modest and the trend was poor, with the second quarter only 3.7% ahead of the prior year's quarter.

But with about half of the S&P 500 reporting to date, the third quarter is running 12% higher, yield on the S&P 500 is more than twice the 10-year Treasury's yield of 2.53%. Historically, the two yields tend to be the same.

Investor Sentiment

This is an area that is getting a lot of attention of late, and one that does concern me, too. A recent AAII Survey showed that 49% of individual investors were bullish, while just 18% were bearish. This compares to long-term averages of 39% bullish and 30% bearish.

There are also a number of signs of excessive optimism on the part of professionals as well, such as the number buying puts (the right to sell a stock at a fixed price) versus calls (the right to buy a stock).

While this much bullishness is worrisome, it typically is only a short-term indicator, rather than a harbinger of a long-term shift in market direction.

The current bull market has now reached 1,697 days-a bit longer than the average of 1,639 days since 1947, but less than the average of 2,118 days for the last five bulls. In short, this bull is certainly no spring chicken, but it's not necessarily an octogenarian either.

What about a correction? We have now gone over 520 days without a 10% pullback. That seems like a lot, but over the past 25 years, there have been two correction-less periods over twice as long as that.

On balance, we are still positive on this long-legged bull market. Looking at everything, as long as the economy continues to make modest progress and interest rates stay well-behaved, corporate profits should continue to grow modestly as well.

We are likely to see more modest returns from the stock market going forward, unless the economy starts to pick up speed. While elevated bullish sentiment may lead to a short-term pullback, a reversal in the favorable long-term trend seems unlikely.

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